Part 7: Everybody in the Pool!

So now we've got lots and lots of marginal people getting mortgages that they prob. shouldn't have, structured in ways that make it very unlikely that they'll be able to pay them off -- partly because of wide-eyed optimism and hopeful thinking on the part of the government, mortgage lenders and the people themselves and partly because of fraud by mortgage applicants and sellers. Regardless, everybody's fine so long as housing prices keep going up...

Then you have all of these mortgages gathered together into massive mortgage backed securities. These have been given quality ratings by the rating agencies -- partly because of fraud-ish greed on the part of the raters and securitizers and partly because, with housing prices going up, they don't look that risky. And so long as housing prices keep going up, they won't be that risky.

Everybody see where the problem is? Everything is predicated on housing prices going up. But that is predicated on an ever expanding group of people to buy these houses. But we've already come up with shady mortgage structures and tossed out the standards just to get to this point. Where are the buyers going to come from to continue propping up these prices?

The answer, of course, was nowhere. And thus housing prices stalled and declined. And, suddenly, these people who took out the ARM and other loans with payments that jump are facing high new rates and a house that's worth less than they borrowed to buy it. And, of course, it's a chain reaction of sorts. A foreclosure in the neighborhood lowers housing prices which traps still further people in the same boat.

So that's what's going on in the neighborhoods. Bad things. People not being able to afford their payments. People watching their house's value decline precipitously.

But what's going on down the line with the securities backed by all these mortgages? Also bad things.

See, for years companies were making a killing on these things. So, naturally, more and more companies got in on the game. They would buy these mortgage backed securities to hold for themselves. Which means that on their balance sheets, they would have an asset that was backed by all of these securities. And that asset would have a value. So what's the value of that asset? Simple, it's whatever you can sell if for.

Perhaps a bit of accounting arcana? You see, financial firms these days are required to use what's called "mark-to-market" accounting. This basically means that all of the various stuff (stocks, bods, mortgage securities, other derivatives, whatever) that comprises the assets of the firm must be valued each day at whatever they would be worth if you sold them all immediately.

Ordinarily this is not a problem. But it can set up nasty chain-reactions if there's a panic. So when the housing market stalled out, suddenly all these billions and billions of dollars of mortgage backed securities didn't look so hot. So lots of firms became eager to get them off the books. So they started selling them. A lot of them. All at once.

As I think most people can guess, when everyone tries to sell the same thing at once, the price crashes. And so the price of these things cratered. But, again, the firms have to record the value of these things as if they were selling them today. So when the price crashes, the value you record also plummets.

Which means, suddenly, you are not holding as many assets as you thought you were. Which can cause all kinds of problems. The credit rating agencies, yes, those same agencies that told you this garbage was AAA-rated, might look at your newly weakened balance sheet and slash your credit rating. Which would then cause all the firms you do business with to ask for more collateral. Which means you need to come up with money fast. But, since your credit rating has been slashed, it's harder for you to borrow at just the time you most need to. So you might well go under.

This is all much more likely to happen if you happen to be a highly leveraged firm -- which all of the investment banks were. Leveraging is a fun and useful concept but I won't get into it here. Just to say that it's been at the heart of every financial collapse, prob. in history. As with everything else, this does not mean it's a bad thing. After all, the internal combustion engine has been at the heart of every traffic disaster and it is a wonderful thing.

At any rate, this is roughly the position that Bear Sterns found itself in. It was facing bankruptcy because the value of the mortgage backed securities that it was holding were plummeting because everybody was selling them and nobody was buying them.

So why was it saved by the Fed? Simple, the Fed gambled that if it could prevent Bear from going under suddenly, it might nip this whole thing in the bud. You see, if Bear had dropped suddenly into bankruptcy, all of its assets would be sold off very, very cheaply. Which would mean that all of the other investment banks holding those assets (we're primarily still thinking of the huge mortgage-backed positions these banks held) would also have to value them at the very cheap price. Which would put more of them into the same boat as Bear, just as surely as a domino knocking down another domino.

Ignoring, for the moment, the Fannie and Freddie stuff, the very same thing played out later with Lehman and AIG. Lehman was allowed to go under because the Fed saw that their bet on Bear hadn't worked and decided they needed to let somebody fail to remind the market that there's no such thing as a free lunch. But this decision ended up having precisely the effect that they were hoping to avoid with Bear: Lehman's bankruptcy meant that their mortgage-backed securities book was suddenly valued much lower.

AIG had a sizable book of similar assets whose value was thus immediately slashed. But it also was among the largest writers of "credit default swaps" (CDS), which basically functioned like insurance on these mortgage backed securities: that is, other firms would enter into a CDS with AIG that basically stated if the value of the mortgage backed securities the firm was holding dropped, AIG would make up some of the difference.

So two things happened so far as AIG was concerned when Lehman failed: its own book of mortgage backed securities was suddenly slashed in value and the potential costs of honoring all of those CDS's suddenly became much higher, at least as of the current valuation. (Again with the "mark-to-market" stuff.)

This did not sink them. What did was that with these developments and probably fearing that their reputations had been harmed by having their fingerprints all over these sub-prime mortgages securities the big three rating agencies decided to get tough. So they immediately threatened to downgrade AIG's credit, which meant that AIG would have to immediately come up with a lot of money. And come up with that money in a market that was skittish and using a credit rating that was lower. Not possible, AIG would go bankrupt trying.

So why did the Fed save AIG? Precisely because of all of those CDS's. You see, all of the banks with large amounts of these mortgage backed securities could avoid valuing them super-low so long as they had these CDS's on them. Going back to the insurance analogy, they could say: "Yes, we have these mortgage backed securities that are collapsing in value. Last year they were worth $100B now they're worth only $35B. But! We have agreements with AIG that limit our losses to $30B, so we are valuing them at $70B." But if AIG goes away, all of a sudden the full loss has to be recognized. Pushing all of those banks closer to the edge, if not over it.

The thing with Fannie and Freddie is a whole other kettle of fish so even though it took place in between the Bear bailout and the Lehman/AIG fiasco, I'll deal with it separately later...